Paper gold pitfalls

May 27, 2012·James Turk

Last year's disastrous collapse of MF Global has impacted financial markets around the world in many ways.

Given that it was one of the largest brokers of leveraged products, it is no surprise that this area has felt the full force of MF Global’s collapse.

For example, futures trading volume on US exchanges has dropped noticeably, mainly for two reasons. First, MF Global customers who are still waiting for their money to be returned are not trading. Second, customers of other brokers have understandably become worried about the safety of their money and withdrawn funds from those firms, which has reduced their capacity to trade.

Gold has not been spared from the MF Global fallout. One of the biggest impacts has been to bring about a better understanding of the risks of owning paper gold. Customers who stored their gold at MF Global received a nasty surprise. As reported by Reuters recently “customers whose accounts were frozen when the futures broker collapsed…[and]...who hold physical property such as gold bars…[have]…seen no recovery as of yet.” MF Global clearly illustrates that owning metal through a brokerage house is a paper-gold product, not physical gold.

It is important to recognise the fundamental difference between paper gold and physical gold, aside from the fact that paper gold enables one to take a leveraged position. With paper gold you own exposure to the gold price; you do not own real gold. Paper gold is a financial asset that comes with counterparty risk, as MF Global’s customers learned. The value of their paper gold was dependent upon a financial institution’s promise. In contrast, physical gold is a tangible asset, with no counterparty risk.

To highlight a key point, there is a lot more paper gold outstanding than physical gold available for delivery. The Comex clearinghouse in New York City and the clearinghouse of other exchanges where leveraged gold products are traded are just one visible part of the paper gold position that exists worldwide. No one really knows how much paper gold has been sold in its entirety, but it is huge.

So as the scramble for physical metal by individuals, central banks and other institutions intensifies, as has been happening during the ongoing banking and sovereign debt crisis of recent years, defaults are possible. They occur when those needing to deliver metal to fulfil their promises do not own any physical metal. In the final analysis, the Comex is no different than the London Metal Exchange, which defaulted on its nickel contract a few years ago. Worryingly, it seems reasonable to conclude that our immediate future unfortunately holds the prospect of seeing the collapse of more financial companies and banks.

For several years, the global economy has been working its way through a financial bust, and throughout history these are always filled with the breaking of promises. For example, Lehman Brothers could not meet its promises, and more recently, the Greek government has been unable to repay its commitments. Therefore, the rule-of-thumb is to avoid financial assets during a financial bust, and by extension, avoid leveraged gold as well.

Given that today’s global monetary and financial problems remain largely unsolved, own physical gold and not any paper-gold substitute. Also, make sure that your gold is not kept with a broker or bank because they are not safe, as Lehman Brothers, MF Global and the failure of other firms have made clear. Instead, always store your metal in the vault of companies who are in the business or storing, not the business of lending or trading leveraged products.

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